Tag Archives: equities

Caution: Mean Reversion Ahead

If you watch CNBC long enough, you are bound to hear an investment professional urging viewers to buy stocks simply because of low yields in the bond markets. While the advice may seem logical given historically low yields in the U.S. and negative yields abroad, most of these professionals fail to provide viewers with a mathematically grounded analysis of their expected returns for the equity markets.

Mean reversion is an extremely important financial concept and it is the “reversion” part that is so powerful.  The simple logic behind mean reversion is that market returns over long periods will fluctuate around their historical average. If you accept that a security or market tends to revolve around its mean or a trend line over time, then periods of above normal returns must be met with periods of below normal returns.

If the professionals on CNBC understood the power of mean reversion, they would likely be more enthusiastic about locking in a 2% bond yield for the next decade. 

Expected Bond Returns

Expected return analysis is easy to calculate for bonds if one assumes a bond stays outstanding till its maturity (in other words it has no early redemption features such as a call option) and that the issuer can pay off the bond at maturity.

Let’s walk thought a simple example. Investor A and B each buy a two-year bond today priced at par with a 3% coupon and a yield to maturity of 3%. Investor A intends to hold the bond to maturity and is therefore guaranteed a 3% return. Investor B holds the bond for one year and decides to sell it because the bond’s yield fell and thus the bond’s price rose. In this case, investor B sold the bond to investor C at a price of 101. In doing so he earned a one year total return of 4%, consisting of a 3% coupon and 1% price return. Investor B’s outperformance versus the yield to maturity must be offset with investor C’s underperformance versus the yield to maturity of an equal amount. This is because investor C paid a 1% premium for the bond which must be deducted from his or her total return. In total, the aggregate performance of B and C must equal the original yield to maturity that investor A earned.

This example shows that periodic returns can exceed or fall short of the yield to maturity expected based on the price paid by each investor, but in sum all of the periodic returns will match the original yield to maturity to the penny. Replace the term yield to maturity with expected returns and you have a better understanding of mean reversion.   

Equity Expected Returns

Stocks, unlike bonds, do not feature a set of contractual cash flows, defined maturity, or a perfect method of calculating expected returns. However, the same logic that dictates varying periodic returns versus forecasted returns described above for bonds influences the return profile for equities as well.

The price of a stock is, in theory, based on a series of expected cash flows. These cash flows do not accrue directly to the shareholder, with the sole exception of dividends. Regardless, valuations for equities are based on determining the appropriate premium or discount that investors are willing to pay for a company’s theoretical future cash flows, which ultimately hinge on net earnings growth.

The earnings trend growth rate for U.S. equities has been remarkably consistent over time and well correlated to GDP growth. Because the basis for pricing stocks, earnings, is a relatively fixed constant, we can use trend analysis to understand when market returns have been over and under the long-term expected return rate.

The graph below does this for the S&P 500. The orange line is the real price (inflation adjusted) of the S&P 500, the dotted line is the polynomial trend line for the index, and the green and red bars show the difference between the index and the trend.

Data Courtesy Shiller/Bloomberg

The green and red bars point to a definitive pattern of over and under performance. Periods of outperformance in green are met with periods of underperformance in red in a highly cyclical pattern. Further, the red and green periods tend to mirror each other in terms of duration and performance. We use black arrows to compare how the duration of such periods and the amount of over/under performance are similar.  

If the current period of outperformance is once again offset with a period of underperformance, as we have seen over the last 80 years, than we should expect a ten year period of underperformance. If this mean reversion were to begin shortly, then expect the inflation adjusted S&P 500 to fall 600-700 points below the trend over the next ten years, meaning the real price of the S&P index could be anywhere from 1500-2300 depending on when the reversion occurs. 

We now do similar mean reversion analysis based on valuations. The graph below compares monthly periods of Cyclically Adjusted Price to Earnings (CAPE) versus the following ten-year real returns. The yellow bar represents where valuations have been over the last year.

Data Courtesy Shiller/Bloomberg

Currently CAPE is near 30, or close to double the average of the last 100 years. If returns over the next ten years revert back to historic norms, than based on the green dotted regression trend line, we should expect annual returns of -2% for each of the next ten years. In other words, the analysis suggests the S&P 500 could be around 2300 in 2029. We caution however, valuations can slip well below historical means, thus producing further losses.

John Hussman, of Hussman Funds, takes a similar but more analytically rigorous approach. Instead of using a scatter plot as we did above, he plots his profit margin adjusted CAPE alongside the following twelve-year returns. In the chart below, note how closely forward twelve-year returns track his adjusted CAPE. The red circle highlights Hussman’s expected twelve-year annualized return.

If we expect this strong correlation to continue, his analysis suggests that annual returns of about negative 2% should be expected for the next twelve years. Again, if you discount the index by 2% a year for twelve years, you produce an estimate similar to the prior two estimates formed by our own analysis.  

None of these methods are perfect, but the story they tell is eerily similar. If mean reversion occurs in price and valuations, our expectations should be for losses over the coming ten years.


As the saying goes, you can’t predict the future, but you can prepare for it. As investors, we can form expectations based on a number of factors and adjust our risk and investment thesis as we learn more.

Mean reversion promises a period of below average returns. Whether such an adjustment happens over a few months as occurred in 1987 or takes years, is debatable. It is also uncertain when that adjustment process will occur. What is not debatable is that those aware of this inevitability can be on the lookout for signs mean reversion is upon us and take appropriate action. The analysis above offers some substantial clues, as does the recent equity market return profile. In the 20 months from May 2016 to January 2018, the S&P 500 delivered annualized total returns of 21.9%. In the 20 months since January 2018, it has delivered annualized total returns of 5.5% with significantly higher volatility. That certainly does not inspire confidence in the outlook for equity market returns.

We remind you that a bond yielding 2% for the next ten years will produce a 40%+ outperformance versus a stock losing 2% for the next ten years. Low yields may be off-putting, but our expectations for returns should be greatly tempered given the outperformance of both bonds and stocks over the years past. Said differently, expect some lean years ahead.

UNLOCKED: RIA PRO Portfolio Trading Action Alert

Since much of the commentary we write is from a “macro view”, many readers, at least judging by the comments we receive, miss the difference between long-range views (the assessment of risk) and the proper portfolio management practices related to navigating the markets (the management of risk.)

This week, we have unlocked out recent portfolio action alert (Subscribe for 30-day FREE Trial) which discusses the recent actions taken in our portfolio. Importantly, the portfolios we run at RIAPRO.Net are “live” accounts and not models.

RIAPRO takes our portfolio management system and puts it online. You can research markets, sectors, and individual stocks, track news and analyst recommendations, and build your own portfolio. Or, you can follow the portfolios we use for our clients.

Over the last couple of weeks we have been suggesting to our subscribers that markets have gotten extremely stretched in the short-term and that a pullback over the next couple of months is likely. From that view, we recently took some actions to raise cash and rebalance portfolio risks accordingly.

While the portfolios are designed to have longer-term holding periods, we understand that things do not always go the way we plan. This monitoring and risk management process keeps us focused on capital preservation and long-term returns.

Before we get into what we did this week, let me give you a quick explanation on how to read the charts.

There are four primary components to each chart:

  • The price chart is contained within the shaded area which represents 2-standard deviations above and below the short-term moving average.  
  • The Over Bought/Over Sold indicator is in orange at the top.
  • The Support/Resistance line (green) is the longer-term moving average which also acts as a trailing stop in many cases.
  • The Buy / Sell is triggered when the green line is above the red line (Buy) or vice-versa (Sell).

When the price of a position is at the top of the deviation range, overbought and on a buy signal it is generally a good time to take profits. When that positioning is reversed it is often a good time to look to add to a winning position or looking for an opportunity to exit a losing position.

NOTE: The portfolio was launched on the 1st trading day of January. So all return numbers are YTD from the point they were added to the portfolio. As noted last week, we said we were going take profits on some of our positions. This week’s position report covers those transactions.

CHCT – Community Healthcare Trust

  • Sold 10% of CHCT at $40.26
  • The position is up 39.30%
  • Stop loss is adjusted to $35

COST – Costco Wholesale Corp.

  • The is the second time we have trimmed COST.
  • We sold 10% at the end of April @ $244.40.
  • We sold 10% this week at $281.39
  • COST is up 35.25% in the portfolio
  • Stop is being adjusted to $240

DOV – Dover Corp.

  • The is the second time we have trimmed DOV.
  • We sold 10% at the end of April @ $97.25
  • We sold 10% this week at $98.28
  • DOV is up 35.14% in the portfolio
  • Stop is being adjusted to $90

MDLZ – Mondelez International

  • The is the second time we have trimmed MDLZ.
  • We sold 10% at the end of April @ $50.55
  • We sold 10% this week at $54.75
  • MDLZ is up 33.59% in the portfolio
  • Stop is being adjusted to $49

MSFT – Microsoft Corp.

  • The is the second time we have trimmed MSFT.
  • We sold 10% at the end of April @ $130.21
  • We sold 10% this week at $137.55
  • MSFT is up 27.67% in the portfolio
  • Stop is being adjusted to $120

V – Visa, Inc.

  • The is the second time we have trimmed V.
  • We sold 10% at the end of April @ $165.46
  • We sold 10% this week at $179.55
  • V is up 34.40% in the portfolio
  • Stop is being adjusted to $155

PG – Proctor & Gamble Co.

  • The is the second time we have trimmed PG.
  • We sold 10% at the end of April @ $105.64
  • We sold 10% this week at $115.26
  • PG is up 19.98% in the portfolio
  • Stop is being adjusted to $100

NSC – Norfolk Southern Corp.

  • The is the second time we have trimmed NSC.
  • We sold 10% at the end of April @ $201.49
  • We sold 10% this week at $196.65
  • NSC is up 30.98% in the portfolio
  • Stop is being adjusted to $180

ABT – Abbott Laboratories

  • We ADDED to our ABT position at the end of April @ $78.65
  • We sold 10% this week at $87.68
  • ABT is up 24.78% in the portfolio
  • Stop is being adjusted to $72.50

VMC – Vulcan Materials, Co.

  • The is the second time we have trimmed VMC
  • We sold 10% at the end of April @ $125.33
  • We sold 10% this week at $138.79
  • VMC is up 30.06% in the portfolio
  • Stop is being adjusted to $120

As we move into the end of summer, the risks are rising that we will likely experience at least a short-term correction of 5-10%. However, with earnings and economic growth continuing to weaken, there is the potential for a larger repricing of risk.

The one overriding concern, from a portfolio management perspective, is that “everyone” seems convinced that “Central Banks” have everything under control and that they have the ability to both avert a recession and keep the bull market going…forever.

From a contrarian point of view, such beliefs reminds me of one of Bob Farrell’s most important investment rules:

“When all experts agree, something else tends to happen.”

Monthly Fixed Income Review – December 2018

The fourth quarter of 2018 was a bad year for lower rated, riskier fixed income products.

In review of December’s fixed-income performance as well as 2018 in general, there are a few key themes that are prevalent.

  1. Interest rates moved higher throughout the first three quarters of the year and then abruptly reversed course and reclaimed nearly 75% of the selloff from the first nine months (5, 7, 10 and 30-year U.S. Treasury bonds).
  2. After outperforming all other primary fixed-income sectors for the first nine months, high yield bonds collapsed in the final three months finishing the year with negative total returns.
  3. Investment grade corporate bonds and emerging market bonds were the worst performing sectors throughout the year losing roughly 2.50%.
  4. Without regard for the direction of interest rates, the yield curve continued to flatten as Fed policy and more recently economic concerns caused the short end (2-year Treasuries) to underperform and the long end (10-year and 30-year bonds) to outperform.
  5. December proved exceptionally strong for safe haven securities like Treasuries, municipal securities and mortgages helping turn those categories positive for the year.

There were numerous times throughout the year when our recommendation to take a conservative tack by moving up in credit and avoiding the more expensive and riskier fixed income categories seemed foolish. In hindsight, the description foolish should be replaced with smart.

Investors can draw a bright line at September 30, 2018 as a point of demarcation. Prior to that date, high yield and other risky sectors like leveraged loans, could do no wrong while every other fixed income asset class languished as interest rates rose. With the economy humming along, employment and hiring robust and inflation concerns burgeoning, the Fed was methodically hiking interest rates. The adjustable rate of interest on leveraged loans made them attractive in a rising rate environment and the higher coupons and shrinking supply of junk bonds (high yield securities) similarly made them appetizing to investors. The last thing investors were worried about in a strengthening economy was credit related losses.

Complacency peaked at the end of September, with fresh record highs in the stock market and favorable returns from its closest proxy, high yield debt. A variety of issues have since emerged as global growth is slowing rapidly and the benefits of domestic fiscal policy move past their point of peak contribution. Needless to say, optimism is waning. The chart below shows how high-yield debt languished in the final three months while safer sectors performed admirably.

As we have expressed throughout the year, there is a lot to worry about in the world and the United States is not immune to those concerns. Concurrently, U.S. markets have assigned expensive prices to the riskiest of assets. For all of 2018, we have urged readers to adjust their investment posture increasingly toward protecting capital. Although now the second longest in recent history, the current expansion has been the weakest on record as it was mostly promoted by artificial stimulus and incremental increases in all forms of debt. Temporarily supportive of growth, rising debt loads create their own headwind and eventually lead to instability. That is in fact what we appear to be witnessing.

The optimists will say that recent underperformance sets the stage for a terrific buying opportunity and that may well be, but value investors are more discerning. The hiccup in performance in the fourth quarter is likely a harbinger of more difficulties to come as China, Europe, Australia and Japan all demonstrate weakening trends in growth and troubling strains from imprudent debt accumulation. It is important to note that approximately 40% of U.S. corporate earnings come from foreign sales.

The United States may soon face similar issues given the sensitivity of our economy to high and rising debt. To the extent that the Fed has properly chosen to wean our economic decision-making off of crisis-era policies, albeit belatedly, those assets that have been the biggest beneficiaries of such policies should also brace to bear the burden of their removal. What we are beginning to see is the lagged effects of higher interest rates and less artificial liquidity as a result – the tightening of financial conditions.

The “tell” has been the Treasury yield curve. Using the spread between 2-year and 10-year Treasury yields, 2018 provided many insights. The 2s-10s curve spread declined throughout most of the year which encompassed both rising rates and falling rates. The price of money, the basis upon which all other assets derive their projections of value, implied that there was a growing concern for rate hikes and inflation (rates up) through the third quarter and then a growing concern for a recession (rates down) thereafter.

Higher risk investment credit is likely to languish for quite some time or at least until the trajectory of the economy becomes clearer. As revealed by high yield bond performance and the direction of interest rates, the trends of 2018 are clear. Our prior guidance of moving up in to higher quality credit and into safer categories of the fixed income markets still holds.

All data courtesy Barclays

Monthly Fixed Income Review – November 2018

The price depreciation of risky assets in the financial markets continued through most of November but took a breather late in the month. The rebound in the final week provided for month-end to month-end optics that were otherwise better than what one might expect had they been watching markets transpire day-to-day.

Performance across the fixed-income sector was reflective of the recent challenges that extended into November. The list of issues included the sell-off of General Electric stock and bonds, Brexit uncertainty and the devastation and financial uncertainty associated with the California wildfires. The market reaction to these events has been justifiably imposing and leaves investors to consider the anxiety-inducing potential for contagion risk.

Money flowed into the safety of Treasuries, mortgages and municipal securities (Munis) and out of corporate bonds and emerging market bonds. As for year-to-date performance, only munis and high-yield corporate bonds are positive at this point, and in both cases, just barely.  All other sectors are negative.

ETFs performed similarly but the Muni bond ETF, unlike the index, is now negative on a year-to-date basis. Somewhat surprisingly and concerning, the emerging market ETF (EMB) is down almost twice the index (-7.24% vs. -3.79%) on a year-to-date basis.

Corporate credit spreads widened meaningfully in November largely offsetting the decline in Treasury yields. Investors appear to be contemplating an imminent slowdown in corporate earnings growth and the associated rating implications. This will be an important story to follow given the large percentage of companies that are BBB, and near junk status. The decline in crude oil prices, down -33% from the early October high, among other languishing commodities raises further concerns about a broader global growth slowdown.

Looking in detail at high yield sector spreads, the best junk rating (BB) widened only modestly (+85 bps) off recent tight levels while the worst rating (CCC) widened substantially (+255 bps).

Considering the drop in the price of crude oil in recent months, an evaluation of the relationship between high yield spreads and oil prices is informative and troubling. As shown in the chart below, crude oil prices below $50 over the past four years are associated with significantly wider high yield spreads.

Finally, there has been a lot of recent discussion about various yield curves beginning to invert. In U.S. Treasuries, the 2y-3y part of the curve is now imperceptibly positive (less than 1 basis point), and the 2y-5y curve is slightly negative. Treasury yields and various curves are highlighted below.

In recent history, an inverted yield curve has implied the eventuality of a recession. Based on the financial media and research from Wall Street, the current yield curve trends are becoming worrisome for investors. While there are good reasons for an economy so dependent on activities associated with borrowing and lending to succumb to an inverted curve, the anxiety being projected is probably more troubling at this stage than the early phase of this event. It is important to watch but should not be a major concern just yet.

Given the volatility in stocks and other risky assets in the early days of December, it remains unclear whether investors should count on the traditional healthy seasonal performance to which they have become accustomed. Uncertainties about the economic and geopolitical outlook loom large, urging a cautious approach and defensive posture in the fixed-income sector. Safer sectors, such as Treasuries, MBS and munis might continue to benefit if recent market turmoil continues.

Data source: Barclays

Post Election Growth Analysis

With the mid-term elections now behind us, we can begin to better assess market dynamics using a known outcome. The Democratic party has regained control of the House of Representatives while at the same time Republicans extended their majority in the Senate. Nevertheless, the power shift in the House will certainly change the political dynamics and increase the level of acrimony on Capitol Hill. The pent-up frustrations of Democrats and their disdain for everything “Trump” seems certain to apply brakes to the agenda of the current administration.

Over the past two years, that agenda has demonstrated itself to be decidedly pro-growth by any means necessary. Of chief concern to us is that growth and prosperity are two very different things. Temporary growth by means of further expanding the country’s debt obligations, as has been the case since the financial crisis, will do nothing for long-term prosperity. Indeed, as the populist movement here and abroad demonstrates, we are already well down the path of sacrificing prosperity for growth.

This matters more so today than in prior years because of the problems we are beginning to see in capital markets as interest rates rise. The advancement of pro-growth strategies fueled by debt and non-productive expenditures by policy-makers has assured a widening of wealth inequality and the populist revolt (if there were another way for us to emphasize that statement, we would). Just to ensure readers do not think us partisan, this is the same strategy advanced to varying degrees by every President and Fed since Franklin Roosevelt in 1933. It certainly does not hold any promise of advancing prosperity to her citizens. Like the socialization of losses in the financial crisis, only a few benefit while the vast majority of the population bears the ultimate and eventual burden.

With Republicans now forced to share power and having less influence in pursuing the Trump plan, it raises an important question: What difference will the congressional split and resulting gridlock make for the economy?

The Signals

Even before the results of this election were known, the bond market was sending confounding signals about the direction of the economy. It can best be described by looking at short-term interest rates (Fed Funds, Eurodollars and 2-Year note Treasuries) on the one hand and longer-term interest rates (10-year notes and 30-year Treasury bonds) on the other. Traditionally, when economic growth picks up steam as an expansion advances, interest rates begin to rise to anticipate that growth may cause rising inflation. Investors’, concerned about the rate of inflation, demand a higher return. Historically, the Federal Reserve (Fed) would follow the markets lead by raising the Fed Funds rate. As higher interest rates begin to cause businesses to be more discriminating in their use of capital for projects, economic activity slows. Responding to that dynamic, long-term interest rates would stop rising and eventually begin to fall well before the Fed lowers short-term interest rates. This causes the yield curve to flatten (or invert).

Data Courtesy St. Louis Federal Reserve

What we see today, in a time when markets have become accustomed to the Fed leading the markets as opposed to following them, is an unusual contrast between the short-end and the long-end of the yield curve. Using the Eurodollar and Fed Funds futures complex as market-based indicators of short-term interest rates, investors imply that the Fed will hike interest rates two times (0.25% each) in 2019 and stop. Meanwhile, the Federal Reserve is telling us through their projection of rate hikes (the dot plot) that they intend to hike rates at least three times in 2019 and possibly more in 2020.

The long end of the yield curve, which is less responsive to Fed Funds expectations and more sensitive to fundamental economic activity like growth and inflation, has recently been steepening. That is to say, although short rates have continued to move higher, the longer end of the yield curve is also moving higher and by a greater magnitude. The 10-year and 30-year Treasury yields are either telling us that economic activity is durably robust and therefore threatens a rise in inflation and/or the longer maturity Treasuries are worried about the amount of issuance required to fund the coming trillion dollar deficits. But if that were the case, it seems the short end would also be mutually expressing those concerns.

Graph courtesy Bloomberg

The conflicting message is that while on the one hand, the market in short rates is underestimating what the Fed is telegraphing regarding rate hikes (2 versus 3), the long end is expressing a concern that the Fed is going to need to be more aggressive.


Like the tax cuts and budget deal passed a few months ago, incremental federal spending going forward can only be funded by expanding the deficit even further. The optics of more fiscal stimulus (i.e., infrastructure spending and tax cuts) will boost near-term estimates of economic growth and likely impose on the Fed to extend plans for rate hikes further. At the same time, larger deficits mean even more Treasury supply at a time when foreign interest is declining which also implies higher interest rates. For an economy so sodden with debt, higher interest rates are problematic which appears to be the outcome no matter what.

Democrats’ control of the House likely puts an end to any such plans as they seem determined to railroad any further stimulus efforts put forth by Trump. That may relieve bond markets from worrying about the risk of even more deficit spending, but it does not atone for past sins and the anvil of debt burdens now hanging around the country’s neck.

For anyone who is unclear about the idea that growth does not equal prosperity, we would argue that you are about to get a first-hand lesson in that difference. If you think Donald Trump and Bernie Sanders were outsiders in the 2016 campaign, the tone in Washington here forward is likely to fuel populist momentum. The only thing we are willing to predict is that of even bigger surprises heading into 2020.



Monthly Fixed Income Review – October 2018

October 2018 was decidedly a “risk-off” month and posed a challenge for every asset class within the fixed-income market. In terms of total return, U.S. Treasuries performed the best (down -0.48%) while investment grade corporates, high-yield and emerging market bonds all posted losses of over 1%. For emerging markets, it was the worst monthly performance since November 2016 and for high-yield, the worst since January 2016. Year-to-date, however, only the high-yield sector remains positive up +0.96%.

A new addition to the monthly fixed-income review is a composite of spread changes as seen in the table below. The data in this table are option-adjusted spreads (OAS). Positive numbers reflect spread widening or higher yields relative to the benchmark which is what normally occurs in months of poor performance. Negative numbers are spread tightening which is constructive. The OAS is measured in relation to the U.S. Treasury benchmark curve.

As illustrated in the table, most OAS spreads are wider across every time frame but not dramatically so. The fact remains that in a historical context, spreads remain very tight to the benchmark. As a point of comparison, current high-yield spreads are 3.71% (371 basis points) above the benchmark curve. In January 2016, they were 7.33% above the benchmark.

In a rather unusual turn of events, despite the sell-off in equity markets, Treasury yields uncharacteristically rose. Over the course of the past 30 years, when we have seen stress emerge in risky assets like that which occurred in October, U.S. Treasuries experience a flight-to-quality bid and yields fall. One could argue that October was an anomaly, but the same thing happened this past February and March.

This irregular relationship may be due to one of a couple of factors, some of both or another unidentified dynamic. Either (1) the correction in equity markets did not stir investors’ fear of a deeper correction given the strength of the economy or (2) on-going concern about heavy U.S. Treasury supply prevented yields from falling. In any event, it is highly unusual and may represent a troubling change in the contour of the markets. The absolute level of interest rates remains low by historical measures but after nearly 10 years of zero-interest rate policies and little volatility, it is the change in rates that matters most to investors and borrowers. Similar increases in rates in prior periods were destabilizing to the equity markets.

The implications of higher interest rates are beginning to show in housing and auto activity. Neither industry, both vital to economic growth in the recent expansion, is collapsing but both are demonstrating a clear weakening trend. In the modern age of excessive debt, this is how topping markets typically progress.

October unveiled another bout of higher volatility, higher interest rates and falling asset prices. This may be a temporary setback but given the age of the cycle, how tight credit spreads are, and the economy’s dependence on debt, we would not advise throwing caution to the wind.


Election Night Cheat Sheet

Historically, the last two years of a president’s term have been great for stock investors as shown below. We can blindly follow history and hope that this is once again the case, or we can examine the facts in front of us and decide if there is reason to be suspect.

Public policy matters to markets and the economy and as a result a significant determinant of the next two years depends on what happens tonight. While the pollsters from both sides of the aisle are claiming victory, the fact of the matter is no one knows what this election may bring. Trump proved the pollsters wrong two years ago and we have little reason to believe they have it right this time. The results depend heavily on the much anticipated “Blue Wave” and whether Democratic turnout can offset the successes, economic and otherwise, of the Trump administration’s first two years.

The question of whether or not the Republicans can keep control of the House and Senate has vast implications for the economy and markets. The following Cheat Sheet provides our latest thoughts on three election result scenarios and what each might mean for the stock and bond markets as well as Federal Reserve policy, the U.S. dollar and economic activity. Please click on the picture to enlarge it.



A Preferred Way to Generate Yield – Part 2 Trade Idea

The following article expands on, A Preferred Way to Generate Yield, by exploring the preferred shares of Government Guaranteed Agency-Backed Mortgage Real Estate Investment Trusts (REIT) and discussing a compelling trade idea within this sector. Neither the common nor the preferred equity classes of this style of REIT are widely followed, which helps explain why the opportunity of relatively high dividends without excessive risk exists.

What is a Mortgage REIT?

Real estate investment trusts, better known as REITs, are companies that own income-producing real estate and/or the debt backing real estate. REITs are legally required to pay out at least 90% of their profits to shareholders. Therefore, ownership of REIT common equity, preferred equity and debt requires that investors analyze the underlying assets and liabilities as well as the hierarchy of credit risks and investor payments within the capital structure.

The most popular types of REITs are called equity REITs (eREIT). They own apartment and office buildings, shopping centers, hotels and a host of other property types. There is a smaller class of REITs, known as mortgage REITs (mREIT), which own the debt (mortgage) on real-estate properties. Within this sector is a subset known as Agency mREITs that predominately own securitized residential mortgages guaranteed against default by Fannie Mae, Freddie Mac, Ginnie Mae and ultimately the U.S. government.

The main distinguishing characteristic between eREITs and mREITs is in their risk profiles.  The shareholders of eREIT securities primarily assume credit risk associated with rising vacancies and declining property values. Most mREITs, on the other hand, take on less credit risk. Instead, their dividends are largely based on interest rate risk or the yield spread between borrowing rates and the return on assets. Agency mREITS that solely own agency guaranteed mortgages take on no credit risk. Mortgage and equity REITs frequently employ leverage which enhances returns but adds another layer of risk.

Mortgage REIT Capital Structures

MREIT’s use debt, common equity, preferred equity and derivatives to fund and hedge their portfolios. Debt is the largest component of their capital structure, often accounting for more than 75% of the financing. Common equity is next in line and preferred equity is typically the smallest. The REITs choice of financing is generally governed by a balance between cost and desired leverage.

When a REIT issues common or preferred equity, leverage declines. Conversely, when debt is employed, leverage rises. The decision to increase or decrease leverage is often a function of balance sheet preferences, hedging strategies, market views and the respective costs of each type of financing. The choice between preferred and common is frequently a function of where the common stock is trading versus its book value as well as the financing costs and liquidity of the two options.

Selecting Agency mREIT Preferred Shares

Agency mREIT (again holding predominately government-guaranteed mortgages) preferred shares currently offer investors a reasonable return with manageable risk. In the current environment there are two primary reasons why we like preferred securities versus their common shares:

  • Discount to Book Value- Currently, several of the Agency mREITs that offer preferred alternatives are trading at price -to- book values below 1.0. While below fair value, we are worried shareholders might get diluted as they are at or near levels where new equity was issued in the past. We prefer to buy the common shares at even deeper discounts (in the .80’s or even .70’s) for this reason. Discriminating on price in this way offers a sound margin of safety where the upside potential is enhanced and risk of new share issuance diminished.
  • Interest Rate Risk- The Fed is raising rates and the yield curve is generally flattening. Profitability of mREITs is largely based on the spread between shorter-term borrowing rates and longer-term mortgage rates. As this differential converges, mREIT profitability declines. Also, as mentioned in our Technical Alert – 30 Year Treasury Bonds, longer-term yields might be reversing a multi-decade pattern of declining yields. While the funding spread is a key performance factor, rising yields introduce complexities not evident in a falling rate environment. Namely, hedging is more difficult and asset prices decline as rates rise. While we still think probabilities favor lower yields, a sustainable break in the long-term trend must be given proper consideration as a risk.

Before selecting a particular REIT issuer and specific preferred shares, we provide a list of all Agency mREIT preferred shares that meet our qualifications.

Data Courtesy Bloomberg

As shown in the Yield -to- Worst column (far right), the lowest expected yields are somewhat similar for all of the issues with five or more years remaining to the next call date.

To help further differentiate these issues, the table below highlights key risk factors of the REITs.

Data Courtesy Bloomberg

The bullet points below describe the four factors in the table:

  • Leverage Multiple– This is the ratio of total assets to common and preferred equity. Higher leverage multiples tend to result in bigger swings in profitability and the potential for a reduction in common and preferred dividends. It is important to note that leverage can change quickly based on the respective portfolio managers view on the markets.
  • Price -to- Book Value (P/B)– This is the ratio of the market capitalization of the common stock to the value of the assets. As the P/B approaches fair value (1.00) the odds increase that common or preferred equity may be issued, putting shareholders at the risk of dilution. The column to the right of P/B provides context for the range of P/B within the last five years.
  • 1 and 3 Year Price Sensitivity– This measures the change in book value as compared to the change in U.S. Treasury yields over selected time periods. This is an indication of hedging practices at each of the firms. The lower the number, the more aggressively they are hedging to protect against changes in yields. This measure, like leverage, can change quickly based on the actions of the firm’s portfolio managers.
  • Preferred as a Percent of Total Equity– This metric offers a gauge of the percentage of preferred shares relative to all equity shares. Preferred shareholders would rather this ratio be small. However, if the number is too low versus competitors, it might mean that preferred shares will be issued soon which would temporarily pressure the price of existing preferred shares.

Trade Idea

Given the current interest rate volatility and the potential for large binary moves in mortgage rates, we think Two Harbors Investment Corporation (TWO) appears to present the least overall risk based on the measures above. In particular, we are focused on their aggressive hedging strategy which has resulted in the lowest interest rate sensitivity over the one and three year time periods. A closer look at performance since June 2016, the point at which interest rates began to rise, also argues in favor of TWO as they have produced superior risk-adjusted total returns.

Data Courtesy Bloomberg

We are largely indifferent between the preferred issues of TWO (A, B and C) shown in the first table. The investor must choose between a preference for a higher coupon and a price above par ($25), and a lower coupon but price below par. On a total return basis, they yield similar results.

TWO spun off Granite Point in the fourth quarter of 2017 and therefore data related to that transaction was adjusted in the table to compensate for the event.

Disclaimer: This material is subject to change without notice. This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation.

The Ghosts Of 2007 Are Calling

Borrowing from Mark Twain, a headline in the Chicago Tribune in 1941 said: “History May Not Repeat, But It Looks Alike.” Real or imagined that is often the case in financial markets especially when perusing historical price charts of stocks, bonds, commodities or any financial instrument for that matter. Comparing charts of some financial index or security from different time frames in search of resemblance is known as an analogue. Although one may occasionally find an uncanny similarity, it does not usually offer much in the way of influence over decision-making. Then again, there are some circumstances where charts align and we would be well-served to pay attention if not for purposes of immediate action, then as a means of allowing for better preparation.

One famous example involved hedge fund manager Paul Tudor Jones who in 1987 picked up on similarities in the price action and chart pattern of the Dow Jones Industrial Average that year and what transpired in 1929. Watching the progression of the stock market in 1987, he was convinced a market crash was coming. And come it did.

While analogues may seem contrived, the concept makes sense. Technical charts in all their forms are simply a reflection of human beings and their decisions about buying and selling. They are a visual representation of human emotion, and although difficult to predict, there is a pattern to how human beings behave in markets.


With that said, the developing price action of the S&P 500 has held our attention for several weeks. Below is a chart of the S&P 500 from two different time frames. The top frame is a chart from October 2006 to November 2007. The bottom frame is from October 2017 to the current day.

Data Courtesy Bloomberg

In early 2007 when everyone felt invincible due to home price appreciation and stock market gains, the first reports of subprime losses began to roil earnings reports for banks. Although initially disruptive, the market shrugged off those concerns and moved higher throughout spring and summer. The S&P 500 hit all-time highs in October, two months before the beginning of the recession and three months before a speech on January 10, 2008, in which Fed Chairman Bernanke stated: “The Federal Reserve is not currently forecasting a recession.”

The equity market contours have definitively changed in 2018 versus preceding years. An initial surge in equities in the opening weeks of 2018 was followed by a 10% decline and a long-absent spike in volatility. However, after the initial disruption in late January, the bull market managed to find its legs. By summer, the market was steadily rising and established new all-time highs in late September.

While the patterns do not line up perfectly, the symmetry of time, record highs, and the confluence of many potentially unstable events is certainly comparable.


If 2006-2007 represents a proper analogue, the all-time high recently set on September 21st was the end of the great post-crisis, stimulus-fueled bull-run. It is early yet, and many prior calls for market tops lie in a graveyard full of bear bones. However, the analogue, when coupled with valuation analysis, liquidity concerns and economic data suggest that there is a likelihood that what we are observing is a topping process to the ten-year bull market.

Unlike 2007 where early disbelief around housing market excess and subprime lending finally offered easily identifiable culprits, today, like terrorism, the villains are not so easily identified. We live so deeply embedded in a world of debt and spending, a world so far away from fiscal discipline and prudence, that the tactics of ultra-low interest rates and quantitative easing now seem natural and healthy. Simply they have blinded our perspective.

Isaac Newton’s third law of physics states that “for every action, there is an equal and opposite reaction.” Years of monetary excess and the rampant speculation that resulted might be finally reversing. Regardless of whether the market is topping as the analogue warns or avoids significant declines for another year or two, investors would be well-served to be aware. The risk/reward framework is not in our favor.

Here Are The Key Levels To Watch In U.S. Stocks

After a pause last week, volatility reared its ugly head again with the Dow falling as much as 548.62 points on Tuesday before recovering most of the losses by the close of trading. Though I am warning that stocks are currently experiencing a bubble that will end in tears (see my presentation about that), I believe in using technical or chart analysis to make sure that I am on the right side of the market’s trend in the shorter-term. In this piece, I will show the key levels in U.S. stock indices that I believe are important to watch.

During this week’s sell-off, the bellwether S&P 500 broke below its uptrend line that began in early-2016, which is a bearish sign if the index closes below this line by the end of this week. If it does, the next major technical support and price target to watch is the 2,550 to 2,600 support zone that formed at the lows earlier this year.

S&P 500 Chart

Unlike the S&P 500, the Dow Jones Industrial Average has not broken below its uptrend line that began in early-2016. If the Dow closes below this uptrend line in a convincing manner on the weekly chart, the next important support level and price target to watch is the 23,250 to 23,500 zone that formed in early-2018.

Dow chart

Like the Dow, the tech-oriented Nasdaq Composite index has not broken its uptrend line yet and actually bounced off this key level on Tuesday. If the Nasdaq eventually breaks below its uptrend line in a convincing manner, the next price target to watch is the 6,600 to 6,800 support zone that formed earlier this year.

Nasdaq chart

The small cap Russell 2000 index broke below its uptrend line two weeks ago, which is a concerning development. The next major support to watch is the 1,425 to 1,475 support zone that formed in late-2017 and early-2018.

Russell 2000 chart

Though the market sell-off of the past two weeks is definitely concerning, more confirmation is needed to determine if a more extensive correction or bear market is imminent. For more information, please read our Chief Investment Strategist Lance Roberts’ technical market update as well.

We at Clarity Financial LLC, a registered investment advisory firm, specialize in preserving and growing investor wealth in times like these. If you are concerned about your financial future, click here to ask me a question and find out more.

Dissecting This Selloff

Comparing the 10% market dip that occurred in the first quarter of 2018 to the current decline can provide us clues as to whether 2018 is a period of consolidation or the makings of a bearish topping process. As the charts reflect, there are some similarities and differences between the two periods.

We start with the weekly chart of the S&P 500 shown below.

Candle Structure

The first two weeks of each sell-off were nearly identical when viewed using candles, as highlighted in the graph below.

Note the similarity of the long second candle in each shaded area which occurred during the second week of each sell-off period. In the January-April timeframe, the second candle was the longest candle of the period, and its bottom proved to be the low for the entire time frame. That low was tested in April and it held. In the current period, the market has so far failed to bounce higher following the early October lows. Further, as of writing this, the S&P 500 has broken below that candle’s low point.

Trend Line Support

During the January – April period, all of the weekly closes stayed above the dotted black trend line, which has reliably supported the market since early 2016. In the current period, the second weekly close finished well below the trend line and the market has continued to trade further below it since.

34-Week Moving Average

While not perfect, the 34 -week moving average (orange) has demonstrated reasonable support for the market since 2016. Currently, the S&P 500 is 80 points below that moving average, and it is not, at least yet, proving supportive. Another weekly close below that level will offer more conclusive evidence of a meaningful breach.

The slope of the 34 -week moving average continued upward throughout the January – April period without any degradation in trajectory. Currently, the slope, while still upward, has flattened considerably.

The 20 -week moving average (green) turned lower in the sixth week of the January – April decline. It turned lower in the second week of the current decline.

The 34 -week moving average and the trend line are important markers to follow. When the market bounces, the next test will be to see if it can rise above these lines or if they become resistance.


In the first week of February, the S&P 500 Volatility Index (VIX) went from 12.5 to over 50. This was a signal of distress in the market and likely a signal of illiquid conditions driven by impetuous selling. That spike was also fueled by concentrated selling due to the failure of poorly constructed short VIX ETFs. Currently, the VIX has risen from the same 12.5 to 25. Our concern is that this move is not as driven by fear which might lead to a more measured and durable sell-off.

Traditional Safe Havens

On January 26, 2018, when the S&P 500 peaked, gold closed at 1352. Over the next three months, as the S&P fell over 10%, gold was never able to close above that level.

On October 3, 2018, when the current decline started gold closed at 1202. As of October 23, it stands above 1230. This time around, unlike the prior decline, gold is reacting positively as a safe haven.

During the first three weeks of the January – April decline, U.S. Treasury yields rose, and prices fell. Typically during periods of market stress, yields decline as investors seek safety. In the current move, yields have declined since early October. While that decline in yields has been moderate, U.S. Treasuries are acting more like a safe haven than earlier in the year.


This second decline of the year is showing signs that are a little more concerning than those offered at the beginning of the year. While the moves may appear somewhat similar thus far in regards to points lost, the differences should be watched closely. The question we must consider is, are we simply in a period of consolidation before the bull market resumes or is this a bearish topping process?

One other comparison bears mentioning. In 2007, the market peaked at record highs in February, recovered and set new record highs over the next eight months before setting a final top in October 2007.

In addition to following the signals detailed above, the low set on February 9, 2018, of 2532 is an important line in the sand. As long as the S&P stays above that line, we must assume the bullish trend since 2009 is intact and the ups and downs of 2018 are merely a period of consolidation. A break below that line leads us to believe further that we may be in the midst of a topping process. Given extreme valuations and the poor risk/reward dynamics offered by stocks, we urge caution and responsiveness as the market further presents itself.

For more on our most current technical thoughts, please read our latest Technically Speaking.

A Preferred Way to Generate Yield

In the current environment investors must dig a little deeper and into less traversed areas of the capital markets to find value. In this article we provide a base knowledge of preferred equity shares, discuss the benefits and risks associated with owning them, and provide comparisons versus other asset classes. This article lays the groundwork for a forthcoming article that will analyze a sub-sector of the preferred market and make a specific trade recommendation.

Fixed-income investors in search of stable income and sufficient yield but wary of excessive risks are likely settling for assets that are sub-optimal. For instance, High-yield corporate debt yields have fallen to near record low levels and yield spreads versus safer fixed-income assets are at their tightest levels in at least the last 20 years. As stated in “High Risk in High Yield” – “As such, the risk/reward proposition for HY appears negatively skewed, and chasing additional outperformance at this point in the cycle appears to be a fool’s errand.”

Equity investors can find somewhat dependable, high-single-digit/low- teen dividend yields in the Master Limited Partnership (MLP) and Real Estate Investment Trust (REIT) sectors. The primary risk of these investments is price volatility which can frequently negate the dividend and much more in adverse conditions.

Fortunately for higher income seekers, there is the preferred stock sector that lies between equity and fixed- income assets in corporate capital structures. This sector tends to be largely underfollowed and not well understood. Because of its relative obscurity and inefficiencies, it can present rewarding options versus other highly followed markets.

What is Preferred Stock? 

Preferred stock is a class of equity issued primarily by financial companies. In a textbook corporate capital structure, preferred shares are a hybrid of debt and equity. In the event of a corporate default, preferred shareholders have a claim on the company’s assets that is secondary to unsecured creditors, such as debt holders, but superior to common equity holders. This hierarchy applies to the distribution of dividends in the normal course of business as well. Debt coupons are paid in full first, then preferred dividends and lastly common equity dividends.

To help offset the risk of non-payment of a preferred dividend, most issues are cumulative, meaning that any missed dividends must be paid before any common equity dividends are paid.

Preferred stock is most commonly issued at a $25 price (par value) and price changes from that point are based on changes to the dividend yield. For example, if a company’s credit conditions are deteriorating or if interest rates in general rise, the price of preferred shares will decline to produce a higher current dividend yield. Prices of preferred shares tend to be relatively stable compared to underlying equity shares. In this respect they are much more bond-like, with price changes a function of the general creditworthiness of the issuer, supply and demand for the issue and the general level of interest rates.

Unlike bonds, most preferred offerings do not have a fixed maturity date.  However, most issues are callable, which allows the company to repurchase the shares at par ($25) after a specified call date. Dividends paid on preferred shares are taxed as long-term capital gains, in contrast with bond coupons which are taxed as income.

The following are key risks to preferred shares:

  • Callable- The ability of the issuer to call, or repurchase, the securities at par ($25) is a risk if the shares are trading above $25. Obviously, the incentive to call preferred shares increases as the price rises. In assessing this risk, the yield – to -call should be calculated.
  • Interest Rate Risk- Like bonds, the price of preferred shares will rise as interest rates fall and fall as rates rise.
  • Credit Risk- Preferred shares fall behind debt in the credit structure. As such, the loss in the event of default could be severe. Further, deterioration of a company’s credit situation will likely push prices lower.
  • Voting Rights- Preferred shareholders do not have voting rights and therefore the holder’s influence on the company’s management is greatly limited.
  • Liquidity- Shares are not as frequently traded as those of common stock. Therefore, bid/offer spreads can widen at times. For those looking to trade in large share blocks, patience over a longer period is required, a contrast with the immediacy of execution for most common shares.

Performance and Risk Comparisons

The table below compares total return performance and yields for the ETF’s of preferred shares and other comparable asset classes. We include a modified Sharpe Ratio which calculates the current dividend/coupon yield to price volatility (risk). This ratio provides a gauge of the amount of risk incurred per unit of dividend. The traditional Sharpe Ratio is backward looking, comparing prior total return performance versus volatility over the same period.

Performance over the last five years has favored preferred shares over corporate debt and has been mixed versus higher yielding equity choices. Importantly, if we presume that price volatility stays at current levels, preferred stocks offer the highest dividends/coupon per level of risk (modified Sharpe).  It is important to note that volatility has been abnormally low for all asset classes over the last five years, and investors in all of the assets shown should expect and account for higher volatility going forward.


Since preferred shares are not widely followed, they can offer investors a value proposition that is elusive in the more traditional markets at times. However, like all higher-yielding securities, they offer above-average yields for a reason. In the case of preferred shares, this is attributable to lower levels of liquidity, and the real and present danger of credit risk. Given the credit assessment required to invest in preferred shares, experience in the fixed- income markets is beneficial in assessing the risks.

As stated above, financial companies are among the most frequent issuers of preferred shares. As such, a bank/financial system-centric economic crisis as experienced in 2008 could be devastating. The preferred ETF (PGF) declined nearly 70% through 2008 and early 2009. Once the Fed halted the decline in the financial sector with the provision of excess liquidity, bailouts, and favorable accounting changes, the sector roared back. By January 2010, PGF had totally recovered all losses while the ETF representing equities of the financial sector (XLF) was still down over 50% from its 2008 highs. Importantly, PGF made all dividend payments during the crisis, and the dividend amounts were on par to slightly higher than those preceding the crisis.

As mentioned, we will soon follow-up to this article with a recommendation of a unique preferred sector and specific shares.


High Risk in High Yield

Tesla’s corporate debt is rated B2 and B- by Moody’s and Standard & Poors respectively. In market parlance, this means that Tesla debt is rated “junk”. This term is often a substitute way of saying “low-rated” or frequently the term “high-yield” is used interchangeably. Tesla’s bond maturing in October of 2021 pays a 4.00% coupon and has a current yield to maturity of 6.29% based on a market price of $93.625 per $100 of face value. Based on prices in the credit default swap markets, Tesla has a 41% percent chance of defaulting within the next five years.

  • The upside of owning this Tesla bond is 6.29% annually
  • The bond’s annual expected return, factoring in the odds of a default and a generous 50% default recovery rate, is 0.17%
  • Should Tesla default an investor could easily lose half of their initial investment.

Tesla is, in many ways, symbolic of the poor risk/return proposition being offered throughout the high-yield (HY) corporate bond market. Recent strength in the HY sector has resulted in historically low current yields to maturity and tight spreads versus other fixed income classes deemed less risky. Given the current state of yields and spreads and the overall risks in the sector, we must not assume that the outperformance of the HY sector versus other sectors can continue. Instead, we must ask why the HY sector has done so well to ascertain the expected future returns and inherent risks of an investment in this sector.

In this article we’ll examine:

  • What is driving HY to such returns?
  • How much lower can yields on HY debt go?
  • Is further spread tightening possible?
  • What does scenario analysis portend for the HY sector?

All data in this article is courtesy of Barclays.

HY Returns

The HY sector, again also known as “junk bonds”, is defined as corporate bonds with credit ratings below the investment grade (IG) rating of BBB- and Baa3 using Standard and Poors and Moody’s rating scales respectively.

The table below presents returns over various time frames and the current yields for six popular fixed income sectors as well as Barclay’s aggregate fixed income composite. As shown, the HY sector is clearly outperforming every other sector on a year-to-date basis and over the last 12 months.

We believe the outperformance is primarily due to four factors.

First, many investors tend to treat the HY sector as a hybrid between a fixed-income and an equity security. The combination of surging equity markets, low HY default rates and historically low yields offered by alternative fixed-income asset classes has led to a speculative rush of demand for HY from equity and fixed income investors.

The following graph compares the performance between the HY aggregate index and its subcomponents to the S&P 500 since 2015. Note that highly risky, CCC-rated bonds have offered the most similar returns to the stock market.

The next graph further highlights the correlation between stocks and HY. Implied equity volatility (VIX) tends to be negatively correlated with stocks. As such, the VIX tends to rise when stocks fall and vice versa. Similar, HY returns tend to decline as VIX rises and vice versa.

Second, the supply of high yield debt has been stable while the supply of higher rated investment grade (IG) bonds has been steadily rising. The following graph compares the amount of BBB rated securities to the amount of HY bonds outstanding. As shown, the ratio of the amount of BBB bonds, again the lowest rating that equates to “investment grade, to HY bonds has been cut in half over the last 10 years.  This is important to note as increased demand for HY has not been matched with increased supply thus resulting in higher prices and lower yields.

Third, ETF’s representing the HY sector have become very popular. The two largest, HYG and JNK, have grown four times faster than HY issuance since 2008. This has led many new investors to HY, some with little understanding of the intricacies and risk of the HY sector.

Fourth, the recent tax reform package boosted corporate earnings overall and provided corporate bond investors a greater amount of credit cushion. While the credit boost due to tax reform applies to most corporate issuers of debt, HY investors tend to be more appreciative as credit analysis plays a much bigger role in the pricing of HY debt. However, it is important to note that many HY corporations do not have positive earnings and therefore are currently not impacted by the reform.

In summation, decreased supply from issuers relative to investment grade supply and increased demand from ETF holders, coupled with better earnings and investors desperately seeking yield, have been the driving forces behind the recent outperformance of the HY sector.

HY Yields and Spreads

Analyzing the yield and spread levels of the high yield sector will help us understand if the positive factors mentioned above can continue to result in appreciable returns. This will help us quantify risk and reward for the HY sector.

As shown below, HY yields are not at the lows of the last five years, but they are at historically very low levels. The y-axis was truncated to better show the trend of the last 30 years.

Yields can decline slightly to reach the all-time lows seen in 2013 and 2016, which would provide HY investors marginal price gains. However, when we look at HY debt on a spread basis, or versus other fixed-income instruments, there appears to be little room for improvement. Spreads versus other fixed income products are at the tightest levels seen in over 20 years as shown below in the chart of HY to IG option adjusted spread (OAS) differential.

The table below shows spreads between HY, IG, Treasury (UST) securities and components of the high-yield sector versus each other by credit rating.

The following graph depicts option adjusted spreads (OAS) across the HY sector broken down by credit rating. Again, spreads versus U.S. Treasuries are tight versus historical levels and tight within the credit stack that comprises the HY sector.

Down in Credit

As mentioned, the HY sector has done well over the last three years. Extremely low levels of volatility over the period have provided further comfort to investors.

The strong demand for lower rated credits and lack of substantial volatility has led to an interesting dynamic. The Sharpe Ratio is a barometer of return per unit of risk typically measured by standard deviation. The higher the ratio the more return one is rewarded for the risk taken.

When long term Sharpe ratios and return performance of IG and HY are compared, we find that HY investors earned greater returns but withstood significantly greater volatility to do so.  Note the Sharpe Ratios for IG compared to HY and its subcomponents for the 2000-2014 period as shown below. Now, do the same visual analysis for the last three years. The differences can also be viewed in the “Difference” section of the table.

The bottom line is that HY investors were provided much better returns than IG investors but with significantly decreased volatility. Dare we declare this recent period an anomaly?

Scenario Analysis

Given the current state of yields and recent highs and lows in yield, we can build a scenario analysis model. To do this we created three conservative scenarios as follows:

  • HY yields fall to their minimum of the last three years
  • No change in yields
  • HY yields rise to the maximum of the last three years

Further, we introduce default rates. As shown below, the set of expected returns on the left is based on the relatively benign default experience of the last three years, while the data on the right is based on nearly 100 years of actual default experience.

Regardless of default assumptions and given the recent levels of volatility, the biggest takeaway from the table is that Sharpe Ratios are likely to revert back to more normal levels.

The volatility levels, potential yield changes and credit default rates used above are conservative as they do not accurately portray what could happen in a recession. Given that the current economic cycle is now over ten years old, consider the following default rates that occurred during the last three recessions as compared to historical mean.

Needless to say, a recession with a sharp increase in HY defaults accompanied with a surge in volatility would likely produce negative returns and gut wrenching changes in price. This scenario may seem like an outlier to those looking in the rear view mirror, but those investors looking ahead should consider the high likelihood of a recession in the coming year or two and what that might mean for HY investors.


An interest rate is the cost for borrowing money and the return for lending money. Most importantly for investors, interest rates or yields help ascertain the amount of risk investors believe is inherent in a security. When one’s risk expectation and those of the market are vastly different, an opportunity exists.

Given the limited ability for yields, spreads, volatility and default rates to decline further, we think the reward for holding HY over IG or other fixed income sectors is minimal. Not surprisingly, we believe the risk of a recession, higher yields, wider spreads, higher default rates and increased volatility carries a higher probability weighting. As such, the risk/reward proposition for HY appears negatively skewed, and chasing additional outperformance at this point in the cycle appears to be a fool’s errand.

For those investors using ETF’s to replicate the performance of the HY sector, you should also be especially cautious. As a point of reference, Barclays HY ETF (JNK) fell 33% in the last few months of 2008. A repeat of that performance or even a fraction thereof would be a high price to pay for the desire to pick up an additional 2.03% in dividend yield over an IG ETF such as LQD.

The bottom line: Markets are not adequately paying you to take credit risk, move up in credit!

Technical Alert – 30 Year Treasury Bonds

One of the biggest economic and market concerns that we harbor is the enormous burden of debt residing on public and private balance sheets. There are two facets to the debt issue that are worth keeping in mind. First, debt plays a large role in funding current economic activity. Second, significant debts from public and private consumption of years past are still outstanding and must be serviced and ultimately paid off.

The technical alert and trade idea discussed in this article is not just for bond investors and traders.  The gravity and ubiquity of this problem is of utmost importance for those forecasting economic growth as well as investors of equities and every other asset class whose returns are predicated on economic activity.

The Lower Forever Scheme

Through inflation targeting and abnormally low interest rates, the Federal Reserve has been complicit in pushing the growth of debt beyond the aggregated ability to pay for it. One look at total debt or the ratio of government debt to GDP graphs makes this clear. Despite a few disruptions, this deliberate policy has driven economic growth but at a very high cost.

The problem for us to consider is that a large amount of economic activity is predicated on ever declining interest rates. Further, the performance of most asset classes has clearly benefited from abnormally low interest rates. Most notably, stocks have once again soared to extremely high valuations in large part for the following reasons:

  • Low interest rates make equities attractive versus low yielding bonds
  • A lower discounting factor makes the present value of future corporate earnings higher
  • Corporations have been able to drastically lower their interest expense while at the same time raising increasing aggregate debt levels
  • Corporations have been able to borrow at will to buy back their stock
  • Individuals and institutions have used excessive margin debt to leverage up their investments
  • Private and public consumption as a result of debt has greatly benefited earnings

There are a variety of questions vital to investors. Among these are the following:

  • Can rates continually keep going lower?
  • Can low interest rates be sustained indefinitely?
  • Can individuals, corporations and the government continue to endlessly accumulate debt with no consequence?

We firmly believe the answer to all of these questions is no. Even with lower rates the burden of debt will become too overwhelming and force various forms of default. That said we are fairly certain the Federal Reserve will do everything in their power to keep rates as low as they can and try to avoid the inevitable.

Chart of the Decade

While this long game plays out we must carefully watch the amount of debt outstanding and more importantly the level of interest rates. Of particular current interest is the long term charts below.

The first graph is the monthly closing price of the 30 year U.S. Treasury bond and its 100 month moving average. The six labeled data points show the times when yields came close to breaching the 100 month moving average but were rebuffed. The second graph compares the monthly closing yield on the bond with the 100 month moving average.

Since October of 1985 the yield on the bond has never been above the moving average on a monthly closing basis. That is until Friday, September 29th, when the closing 30 -year yield on the U.S. Treasury bond was 3.197% and the 100 month moving average was 3.160%. As shown on the second graph, this is the first time the moving average has failed as a point of resistance in over 30 years.

A few basis points is cause for concern but not yet a technical break in our opinion. Despite breaching it by only 3.70 basis points we think it is quite possible that yields turn lower and prove the moving average as valid resistance.  We emphasize caution however with this view, if yields are truly breaking out to the upside, investors of bonds and most other asset classes should be on alert.

Trade Idea

From a trading perspective, the current set-up in the 30-year bond offers a favorable risk/return construct. Taking a long position in the bond with a tight stop loss level, limits risk and allows for upside if yields bounce off of the resistance line.

The table below provides three and six month total return figures for the six instances labeled in the graph above. As shown all six instances provided investors substantive three and six month total returns. Further, at any point during the six periods any temporary losses were more than offset by coupon payments.

The trade can be executed using the 30-year U.S. Treasury bond, 30-year U.S. Treasury bond futures or iShares Barclays 20+ Year U.S. Treasury Bond ETF (TLT). We recommend a stop loss of ten basis points of yield which would result in a possible loss of approximately 1.95% less any coupon earned during the holding period.

If you are using TLT to execute this trade, 10 basis points is equal to approximately 2 points based on the current price of 117.38 and a duration of 17 years for the ETF.


Disclaimer: This material is subject to change without notice. This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation.



Following Signs Others Ignore : VIX

“In fact, the crowd sees hardly anything out there that might end this market party.”

Michael Santoli made the above statement during CNBC’s closing market wrap on January 26th, 2018. He had reason to throw caution to the wind as the S&P 500 closed the day up by more than 1%, setting another record high. In the first 18 trading days of 2018, the S&P 500 set 14 record highs and amassed a generous 7.50% return for the year.

As quoted, CNBC and most other financial media outlets were exuberant over the prospects for further gains. Wall Street analysts fell right in line. Despite the fact it was not even February, some Wall Street banks were furiously revising their year-end S&P 500 forecasts higher.

On January 27th, the S&P 500 closed down 0.70%, and in less than three weeks, the index fell over 10% from the January 26th high. Very few investors harbored any concern that the rare down day on the 27th was the first in a string of losses that would more than erase 2018’s gains to that point.

Looking back at the January swoon, there were a few indicators that CNBC, others in the media, and those on Wall Street failed to notice. In mid-January, we noticed an anomaly which proved to be a strong leading indicator of what was ultimately to transpire. The purpose of this article is to re-introduce you to this indicator, as it may once again prove helpful. We’ll also remind you why ignoring media and Wall Street driven hype is important.


VIX is the abbreviation for the Chicago Board of Options Exchange (CBOE) Volatility Index, which gauges the amount of implied volatility in the S&P 500 as measured by pricing in the equity options market.

When optimism runs high, investors tend to seek less downside protection and as such VIX tends to decline. Conversely, when markets are more fearful of the downside, VIX tends to rise as investors are willing to pay higher prices for protection via the options market. While not a hard and fast rule, VIX tends to be elevated in down markets and subdued in bullish markets. This historical relationship is shown below. The beige rectangles highlight recent market drawdowns and the accompanying VIX spikes.

Data Courtesy Bloomberg

Another way to show the relationship is with a scatter plot. Each dot in the plot below represents the percentage change in VIX and the associated percentage change in the S&P 500 for the prior 20 days. The data goes back to 2003. While there are outliers, the graph generally illustrates an inverse relationship, whereby a higher VIX is associated with lower S&P returns and vice versa.

Data Courtesy Bloomberg

January 10th-26th

With an understanding of volatility and its general relationship with market direction, we return to the 12 trading days leading up January 27th. The graph below charts the VIX index and the S&P 500 from January 1st to the 26th.

Data Courtesy Bloomberg

The obvious takeaway is that the VIX and the S&P rose in unison. Despite a euphoric financial media, daily record highs and a strong upward trend, investors were increasingly demanding insurance in the options markets.

The scatter plot and its trend lines below show this divergence from the norm. The orange dots represent the daily VIX and S&P changes from the 10th to the 26th while the blue dots represent every trading day from January 1, 2017, thru August 2018.

Data Courtesy Bloomberg

From January 27, 2018 to early March, the VIX was trading over 20, twice the general level that prevailed in early January and throughout most of 2017. The elevated VIX and weak market resulted in a normalization of the typical inverse relationship between volatility and equity performance, and it has stayed normal ever since. The green dots and green trend line in the graph below represent data since January 27th. The divergence and normalization can best seen by comparing the trend lines of each respective period.

Data Courtesy Bloomberg

Tracking VIX

In addition to identifying the relationship as we did in January, we must monitor this relationship going forward. We show two additional metrics for VIX and S&P 500 below that we created to alert us if the typical inverse relationship changes.

  • Running Correlation: Calculates the correlation between the VIX and the S&P 500 on a rolling 10-day The highlighted area on the line graph below shows the departure from the norm that occurred in mid-January.
  • Anomaly Count: Counts the number of days in a period in which the S&P was higher by a certain percentage and the VIX rose. In the second chart below, the blue bars represent the number of trading days out of the past 20 days when the S&P 500 rose by more than .50% and the VIX was higher.

Data Courtesy Bloomberg

Data Courtesy Bloomberg


Markets do not suddenly drop without providing hints. As we discussed in our article 1987, the devastating Black Monday 22.60% rout was preceded by many clues that investors were unaware of or, more likely, simply chose to ignore.

Currently, most technical indicators are flashing bullish signals. Conversely, most measures of valuation point to the risk of a major drawdown. This stark contrast demands our attention and vigilance in looking for any data that can provide further guidance. The VIX is just one of many technical tools investors can use to look for signals. We have little doubt that, when this bull market finally succumbs to overvaluation and the burden of imposing levels of debt, clues will emerge that will help us anticipate those changes and manage risk appropriately.